The Federal Reserve’s Daniel Tarullo give a speech last Friday called “Shadow Banking and Risk Regulation,” in which he laid out a few new ideas for regulating securities finance transactions (SFTs) including repo and securities lending. Most of the speech was old news for those of us who follow shadow banking but some of the new ideas warrant closer investigation.
Tarullo is basically looking at ways to tax securities finance. He puts this in the language of regulatory capital charges but in effect the outcome will be to make transactions more expensive. Given the choice between constraints from the Leverage Ratio (see our analysis from Nov 13, “What will be the gating factor in sec finance, the LCR or the Leverage Ratio?“) and a direct tax that winds up being pretty moderate, we think the tax makes better policy sense. This would be applied across all institutions evenly as opposed to the Leverage Ratio which would affect some institutions more than others and artificially shift business around. With one of the new ideas, presumably SFTs would then be excluded from some of the Leverage Ratio or LCR calculations and a new type of tax implemented instead.
Tarullo lays out two main options:
“The first would impose a regulatory charge calculated by reference to reliance on SFTs and other forms of short-term wholesale funding, whether the firm uses that funding to finance inventory or an SFT matched book.”
This idea is a capital charge relative to how much SFT was being conducted. Tarullo says that “the additional capital requirement would be calculated by reference to a definition of short-term wholesale funding, such as total liabilities minus regulatory capital, insured deposits, and obligations with a remaining maturity of greater than a specified term.” This ought to push dealers towards more long-term debt financing, which they are doing anyhow, and allocate costs of repo to those who engage in the transactions. There would be no inherent limit on those transactions at the bank level except what capital charges would require and the market would bear in terms of pricing.
“The second would directly increase the very low charges under current and pending regulatory standards attracted by SFT matched books.” This would stick to the current Basel III model and may be easier (but in our view less desirable) than getting into conversations about revising Basel III’s core concepts.
Tarullo also points out that many other firms engage in SFTs besides banks and that no regulation yet captures these activities. The great example is that hedge funds may conduct direct repo transactions (check out this Finadium subscriber only article from April, “Who does Shadow Banking when banks can’t?). He also catches the regulatory arbitrage opportunity of trading derivatives instead of physical assets to avoid taxes specifically linked to the physical.
The Federal Reserve is now getting to the heart of their long discussed interest: what policies make securities finance transactions safer in an interlinked global financial environment. Their main idea is either higher capital cushions for firms that are involved or some sort of direct taxes for the actual transaction. They are also paying attention to the fact that outside of large banks, potentially substantial securities financing transactions, such as hedge funds doing repo with non-bank counterparties, could occur.
We think the Fed is on the right track. However, we also think that these policy measures require careful analysis before implementation. We like the capital charge idea more than we like the Leverage Ratio as a gating factor. Still, any tax needs to be reasonable relative to its benefits and consequences.
Tarullo’s full speech can be found here.